The hedge fund administration business is booming, but investors need to be aware of the nuances as to how these services work, according to a recent article in Fortune online.

Hedge Fund administrators are third-party firms that try to make hedge funds more transparent for investors. They are tasked with making sure that trades occur, that net asset value (NAV) of a fund is accurate, and that a hedge fund actually owns the assets it claims to own. It’s an important part of the due diligence investors must perform on any hedge fund in which they invest. Recent events, including the Bernie Madoff scandal, have given such reporting an even higher importance.

But these administrators often get their data directly from the hedge funds themselves, notes Fortune, and they are not legally obligated to confirm that the information is correct.

In addition, the more complex a hedge fund strategy, the tougher it gets to verify the details of transactions and assets under management. For highly liquid stocks and bonds, an administrator can tap into well-known databases such as ThomsonReuters or Bloomberg. But things get considerably more challenging and expensive when an administrator has to obtain data on illiquid securities or derivatives. It’s an expense that many smaller hedge funds often can’t afford.

As a result, the hedge fund administrators often take a hybrid approach: getting what they can from readily available databases, and getting the rest of the data from the hedge funds themselves.  And while this approach may be disclosed in the fund offering documentation, investors don’t always pay attention to the fine print.

Recently, investors in a hedge fund called Lancer, were burned by reports from Citco, the world’s largest hedge fund administrator. According to published reports, Lancer bought stock in a worthless shell company, plus shares on the open market at a higher price to show a gain. The artificially inflated data was given to Citco who used the figures in their monthly reports.

In a subsequent lawsuit, Citco claimed it did everything it was legally required to do, and thus should not be held accountable for any losses suffered by investors.

It’s crucial for smart investors to be able to verify and trust the data provided by hedge funds. And one would imagine that is a valuable part of building trust and marketing your hedge fund as well. Hedge funds should be willing to cover the costs of gathering the right data when working with hedge fund administrators.

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